Big changes sometimes occur during the life cycle of a contract. Cancelling a contract outright can be bad for your reputation and your bottom line. Businesses need to know how to best address a change in circumstances, while also protecting their legal rights. One option is to transfer the "benefits and the burdens" of a contract to another party using a novation agreement. Unlike amending the terms of the original contract, a novation agreement creates a new three-way contract. It terminates the original contract and replaces it with a new one. In this new contract, a third party takes up the rights and obligations of one original party.
What Is a Novation Agreement?
The word "novate" means to replace an old obligation with a new one. In a novation, a new party takes over the rights and obligations of the original party. This transfer releases the original party from its obligations.
For example, if a supplier can no longer provide goods to a customer, it can reduce the risk of liability by finding another source for the customer. If all three parties agree, the existing contract can voided and replaced with a new contract that substitutes the new supplier for the original one. The agreement effectively releases the original supplier from any further liability under the original contract.
Novation agreements are used in a wide range of other business situations. During mergers and acquisitions, they can help ensure continuity of operations and facilitate a smooth transition. In an acquisition, a novation agreement allows the acquiring company to assume all the rights and obligations of the target's existing contracts. Similarly, in a merger, the newly formed company can use novation agreements to assume the contractual responsibilities of the two merging companies and streamline operations.
What Is the Difference Between a Novation and an Assignment?
It is important to understand how a novation agreement is different from an assignment. A novation transfers the benefits and liability of the original contract to a new party. Conversely, an assignment only transfers the rights/benefits of the contract to a new party; the obligations of the agreement remain with the original contracting party.
For the original contracting party, a novation provides stronger legal protection because you are completely released from your obligations. In an assignment, you may still be held liable if the third party fails to fulfill its obligations. The benefit of an assignment is that it generally does not require the consent of the new party.
What Are the Requirements of a Novation Agreement?
While a novation agreement is a complex legal agreement with a number of moving parts, it essentially involves four key steps:
- Agreement: All of the parties to the original contract must agree to the novation. The new third party must also agree to assume the rights and obligations of the original party. Some amount or type of consideration must also be provided in the new contract.
- Contract Terms: Among other key contract terms, the new contract should summarize the details of the existing contract, clearly state the intent of the parties to replace the old contract with the new one; and set forth the terms of the new parties, including the date the agreement will take effect, the rights and obligations that are being transferred, and the date of termination.
- Release: The novation agreement should include a release clause expressly stating that once the novation is executed, the original party is released from its obligations and also forfeits any rights that it had against the other original party.
- New Contract: While the new contract may be similar to the original contract, it is a completely separate agreement. Additionally, once the novation agreement takes effect, the original contract is void.
Once the novation agreement is final, the parties should notify any other parties that may be impacted, such as vendors, subcontractors, regulators, or lenders
Consult With an Experienced Business Contract Attorney
A novation is a complex undertaking, and missteps can lead to significant liability. To ensure the enforceability of a novation agreement, it is wise to work with experienced legal counsel.
At Scarinci Hollenbeck, the attorneys of our Corporate Transactions & Business Group have decades of experience drafting, reviewing, and negotiating commercial contracts for businesses of all sizes. We provide tailored solutions that safeguard our clients' legal interests and advance their business goals.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
